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December 28, 2007

Promoting Fiscal Discipline - Fiscal Responsibility Laws

Posted by Mario Pessoa

Fiscal discipline is essential to improve and sustain economic performance, maintain macroeconomic stability, and reduce vulnerabilities. Discipline is especially important if countries, industrial as well as developing, are to successfully meet the challenges, and reap the benefits, of economic and financial globalization. Lack of fiscal discipline generally stems from the injudicious use of policy discretion. The benefits of discretion are seen in terms of the ability of policymakers to respond to unexpected shocks, and in allowing elected political representatives to fulfill their mandates. But discretion can be misused, resulting in persistent deficits and pro-cyclical policies, rising debt levels, and, over time, a loss in policy credibility.

A recent IMF book entitled "Promoting Fiscal Discipline", edited by by Manmohan Kumar and Teresa Ter-Minassian, addresses some of the key issues involved in promoting fiscal discipline, with particular emphasis on output stabilization and the cyclicality of fiscal policy, and on ways to avoid procyclicality in good times. It examines the role and determinants of fiscal discipline (chapter 1), the extent, consequences, and causes of procyclicality, and “mechanisms that could help reduce procyclicality and strengthen fiscal discipline-targeting cyclically adjusted fiscal balances (chapters 2 to 4), the introduction of fiscal responsibility laws (chapter 5), and the creation of nonpartisan fiscal agencies (chapter 6).

In Chapter 5, Gerd Schwartz and Ana Corbacho discuss the main characteristics of fiscal responsibility laws (FRL) implemented in some developed and developing countries. It presents an evaluation of its effectiveness based on 13 country case study (Argentina, Australia, Brazil, Colombia, Ecuador, India, New Zealand, Panama, Pakistan, Peru, Spain, Sri Lanka, and The United Kingdom).

Fiscal Responsibility Laws

In 1994 New Zealand approved a Fiscal Responsibility Act in order to strengthen fiscal discipline and improve transparency and accountability. Then, many other countries followed the example by passing fiscal responsibility laws (FRL). But emphasis in terms of the measures implemented varied in two basic approaches: one focused on procedural rules and the other in numerical rules.

According to the study, the main reason to have a FRL was the perception that fiscal discipline was not been maintained voluntarily and that it was necessary to introduce additional legislation in order to guarantee compliance. Many factors can explain the misuse of discretion: short-term horizon of politicians, political and distributive conflicts in budgetary allocation, and time inconsistency in relation to fiscal policy.

The chapter recognizes that procedural and transparency rules in and by themselves may be insufficient to strengthen fiscal policies; however, they may help by making the budget process more hierarchical. On the other hand, numerical fiscal rules may help to contain a deficit bias and address problems of time inconsistency, address the expenditure bias, and target pro-cyclical expenditure.

The potential disadvantages of numerical rules include lack of flexibility in fiscal policy and incentives to rely on low-quality measures to meet the targets.

The scope of FRL varies from country to country, but the FRL have some remarkable features that can explain their different levels of success:

sanctions (can be institutional, personal, or not be contemplated – LRFs with sanctions are more effective);

escape clauses (provisions to limit or suspend the rule if special circumstances happen, such as natural disasters, war, and calamities – too generous escape clauses can undermine its credibility); and,

cyclical considerations (creation of funds to support anti-cyclical expenditure – existence of funds add a long-term perspective that strengthen credibility).

But FRL by itself is not enough to guarantee fiscal discipline. Other factors such as existence of sound budget institutions, political consensus for prudent fiscal policy, political commitment to observe the rules, existence of a sound public financial management system, quality of fiscal information, adequate coverage of the budget, and overall transparency of budget execution and reporting are essential elements to fiscal discipline.

The paper also provides a summary of the main fiscal rules applied in 13 countries (Argentina, Australia, Brazil, Colombia, Ecuador, India, New Zealand, Panama, Pakistan, Peru, Spain, Sri Lanka, and The United Kingdom).